The severity of the ongoing economic crisis in the Eurozone is perhaps best brought home by a striking statement made Monday by conservative Polish politician Radek Sikorski. "I will probably be the first Polish foreign minister in history to say this," he said, "but here it is: I fear German power less than I am beginning to fear its inactivity."
Poland is not in the Eurozone, but it’s easy to see why Polish officials are panicking. Exports to the Eurozone members constitute more than 10 percent of Polish GDP, so a recession there would almost certainly spill over to Poland.
Should Americans share this fear? A similar analysis for the United States suggests we have much less to worry about. Our exports to the Eurozone are closer to 1.3 percent of GDP. That’s not nothing, but it’s a pretty small piece of the economic pie. It suggests that the economy has less to fear from reduced exports to a careening Europe than it does from the looming expiration of the Bush income tax cuts and the Obama payroll tax cuts.
But a different kind of analysis suggests that the United States could face catastrophe if the Eurozone tanks.
This terrifying possibility is suggested in a Nov. 7 lecture by Princeton professor Hyun Song Shi, “Global Banking Glut and Loan Risk Premium” (PDF). The starting point for his analysis is the fact—well-known to financial practitioners, unknown to the public, and perennially rediscovered by the economics profession—that a very large share of the world’s dollars are held in non-American accounts. Indeed, for several years in the late aughts the total dollar assets of non-American banks actually exceeded the total assets of the U.S. commercial banking system and even today the ratio is close to 1:1.
These foreign dollars—mostly held by European-headquartered global conglomerates—are not isolated from the American economy. Just as U.S. firms and households deposit money in American banks and take loans from the banks, European global banks intermediate between savers and spenders of dollars. A 2010 Bank of International Settlements survey (PDF) revealed that as of 2009, 161 foreign banks were operating 226 branches in the United States that raised more than $1 trillion in wholesale funding, largely through money markets. Dollars raised in the United States tend to ultimately work their way back to the United States (which, after all, is where you can use dollars to buy things) through the shadow banking system. European banks aren’t the only ones in this game, but they are the largest player. The upshot is that decisions made in Europe about how much leverage to take on play almost as big a role in determining American credit conditions as do decisions made in the United States.
The lecture goes on to argue that European decision-making played a large role in inflating the now departed credit bubble of the mid-aughts, an interesting technical issue that needn’t keep you up late at night. The implication, however, is that a massive and sudden contraction of the European banking system would have the effect of automatically contracting credit conditions in the United States. If European credit markets tightened, the dollars held by European banks would suddenly become much less available as the basis for lending to American financial intermediaries and, ultimately, firms and households.
As George Mason University economist Tyler Cowen put it "if true, we are doomed."
It sounds counterintuitive to believe that less lending and less debt could be a problem when we’re currently suffering from the excessive borrowing of the past. But this hangover theory is mistaken. Less credit and less borrowing now will only make our problems worse. Some currently solvent enterprises and households will be pushed into bankruptcy by difficultly rolling over their current debt. Others will curtail purchases and investments. Both factors will reduce incomes and drive overall spending down, further adding to America’s already large stock of idle facilities and unemployed workers. The punch will come, in other words, not because the collapse of the European banking system will cripple the European economy and thus indirectly hurt our ability to sell things to Europeans. Instead the collapse of the European banking system will directly cripple an American economy that depends on European banks to provide a fair share of our credit. The middling growth of the past year has been powerfully driven by an incredible boom in equipment and software investment by American firms that could dry up overnight and deal a devastating blow to an already fragile economy.
Conventional thinking about Europe’s difficulties does not yet appear to take the effect on American credit markets into account. Yesterday the Organization for Economic Cooperation and Development released updated economic forecasts reflecting new pessimism wherein “Euro area growth is forecast to slow down from 1.6 percent this year to 0.2 percent next year” while having only a modest impact on an American economy that will still grow 2 percent.
We can cross our fingers and hope that’s right, but since 2008 policymakers have suffered from a bias toward optimism. Europeans were initially far too smug about the idea that they were insulated from problems relating to a housing bubble on the other side of an ocean. Then, in 2010, American policymakers were far too impressed by good news from the labor market and leapt to unwarranted conclusions about a “recovery summer.” Now the risk is that American leaders will overestimate our degree of insulation from the European banking system. You never want the people in charge to actually set off a panic by speaking too soon about hypothetical calamities, but we’d all better hope that somewhere in the basement of the Treasury Department and the Federal Reserve they’re prepping a Plan B to keep money flowing even if European finance dries up.
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Happy Constitution Day!
Too bad it’s almost certainly unconstitutional.